Don’t fear a ris­ing dol­lar

Janet Yellen, the Fed chair, has re­peat­edly said that the im­pend­ing se­quence of rate hikes will be much slower than pre­vi­ous mon­e­tary cy­cles, and predicts that it will end at a lower peak level. While cen­tral bankers can­not al­ways be trusted when they make such prom­ises, since their jobs of­ten re­quire them de­lib­er­ately to mis­lead in­vestors, there are good rea­sons to be­lieve that the Fed’s com­mit­ment to “lower for longer” in­ter­est rates is sin­cere.

The Fed’s over­rid­ing ob­jec­tive is to lift in­fla­tion and en­sure that it re­mains above 2%. To do this, Yellen will have to keep in­ter­est rates very low, even af­ter in­fla­tion starts ris­ing, just as her pre­de­ces­sor Paul Vol­cker had to keep in­ter­est rates in the 1980s very high, even af­ter in­fla­tion started fall­ing. This pol­icy re­ver­sal fol­lows log­i­cally from the in­ver­sion of cen­tral banks’ ob­jec­tives, both in Amer­ica and around the world, since the 2008 cri­sis.

In the 1980s, Vol­cker’s his­toric re­spon­si­bil­ity was to re­duce in­fla­tion and pre­vent it from ever ris­ing again to dan­ger­ously high lev­els. To­day, Yellen’s his­toric re­spon­si­bil­ity is to in­crease in­fla­tion and pre­vent it from ever dan­ger­ously low lev­els.

Un­der th­ese con­di­tions, the direct eco­nomic ef­fects of the Fed’s move should be min­i­mal. It is hard to imag­ine many busi­nesses, con­sumers, or home­own­ers chang­ing their be­hav­ior be­cause of a quar­ter­point change in short-term in­ter­est rates, es­pe­cially if long-term rates hardly move. And even as­sum­ing that in­ter­est rates reach 1-1.5% by the end of 2016, they will still be very low by his­toric stan­dards, both in ab­so­lute terms and rel­a­tive to in­fla­tion.

The me­dia and of­fi­cial pub­li­ca­tions from the In­ter­na­tional Mon­e­tary Fund and other in­sti­tu­tions have raised dire warn­ings about the i mpact of the Fed’s first move on fi­nan­cial mar­kets and other economies. Many Asian and Latin Amer­ica coun­tries, in par­tic­u­lar, are con­sid­ered vul­ner­a­ble to a re­ver­sal of the cap­i­tal in­flows from which they ben­e­fited when US in­ter­est rates were at rock-bot­tom lev­els. But, as an em­pir­i­cal mat­ter, th­ese fears are hard to understand.

The im­mi­nent US rate hike is per­haps the most pre­dictable, and pre­dicted, event in eco­nomic history. No­body will be caught un­awares if the Fed acts next month, as many in­vestors were in Fe­bru­ary 1994 and June 2004, the only pre­vi­ous oc­ca­sions re­motely com­pa­ra­ble to the cur­rent one. And even in those cases, stock mar­kets barely re­acted to the Fed tight­en­ing, while bond­mar­ket volatil­ity proved short-lived.

But what about cur­ren­cies? The dol­lar is al­most uni­ver­sally ex­pected to ap­pre­ci­ate when US in­ter­est rates start ris­ing, es­pe­cially be­cause the EU and Ja­pan will con­tinue eas­ing mon­e­tary con­di­tions for many months, even years. This fear of a stronger dol­lar is the real rea­son for con­cern, bor­der­ing on panic, in many emerg­ing economies and at the IMF. A sig­nif­i­cant strength­en­ing of the dol­lar would in­deed cause se­ri­ous prob­lems for emerg­ing economies where busi­nesses and gov­ern­ments have taken on large dol­lar­de­nom­i­nated debts and cur­rency devaluation threat­ens to spin out of con­trol.

First, the di­ver­gence of mon­e­tary poli­cies be­tween the US and other ma­jor economies is al­ready uni­ver­sally un­der­stood and ex­pected. Thus, the in­ter­est-rate dif­fer­en­tial, like the US rate hike it­self, should al­ready be priced into cur­rency val­ues.

More­over, mon­e­tary pol­icy is not the only de­ter­mi­nant of ex­change rates. Trade deficits and sur­pluses also mat­ter, as do stock­mar­ket and property val­u­a­tions, the cycli­cal out­look for cor­po­rate prof­its, and pos­i­tive or neg­a­tive sur­prises for eco­nomic growth and in­fla­tion. On most of th­ese grounds, the dol­lar has been the world’s most at­trac­tive cur­rency since 2009; but as eco­nomic re­cov­ery spreads from the US to Ja­pan and Europe, the ta­bles are start­ing to turn.

Fi­nally, the widely as­sumed cor­re­la­tion be­tween mon­e­tary pol­icy and cur­rency val­ues does not stand up to em­pir­i­cal ex­am­i­na­tion. In some cases, cur­ren­cies move in the same di­rec­tion as mon­e­tary pol­icy – for ex­am­ple, when the yen dropped in re­sponse to the Bank of Ja­pan’s 2013 quan­ti­ta­tive eas­ing. But in other cases the op­po­site hap­pens, for ex­am­ple when the euro and the pound both strength­ened af­ter their cen­tral banks be­gan quan­ti­ta­tive eas­ing.

For the US, the ev­i­dence has been very mixed. Look­ing at the mon­e­tary tight­en­ing that be­gan in Fe­bru­ary 1994 and June 2004, the dol­lar strength­ened sub­stan­tially in both cases be­fore the first rate hike, but then weak­ened by around 8% (as gauged by the Fed’s dol­lar in­dex) in the sub­se­quent six months. Over the next 2-3 years, the dol­lar in­dex re­mained con­sis­tently be­low its level on the day of the first rate hike. For cur­rency traders, there­fore, the last two cy­cles of Fed tight­en­ing turned out to be clas­sic ex­am­ples of “buy on the ru­mor; sell on the news.”

Of course, past per­for­mance is no guar­an­tee of fu­ture re­sults, and two cases do not con­sti­tute a sta­tis­ti­cally sig­nif­i­cant sam­ple. Just be­cause the dol­lar weak­ened twice dur­ing the last two pe­ri­ods of Fed tight­en­ing does not prove that the same thing will hap­pen again.

But it does mean that a rise in the dol­lar is not au­to­matic or in­evitable if the Fed raises in­ter­est rates next month. The glob­ally dis­rup­tive ef­fects of US mon­e­tary tight­en­ing – a rapidly ris­ing dol­lar, cap­i­tal out­flows from emerg­ing mar­kets, fi­nan­cial dis­tress for in­ter­na­tional dol­lar bor­row­ers, and chaotic cur­rency de­val­u­a­tions in Asia and Latin Amer­ica – may loom less large in next year’s eco­nomic out­look than in a rear-view glimpse of 2015.